A cash flow statement is simply a record of a firm's financial transactions, that is, money received and money spent over a given period of time. It is one of the four most important financial statements and it reveals the short term viability of the firm. A properly documented cash flow shows the sources of cash generated from operations, investment and financial activities (BNET 2010).
Analysts and investors also considered the cash flow as the life blood of any business. Cash flow is used as a core indicator of a firm's financial health and viability and it is considered as a good gauge to quickly judge a firm's financial performance. As an indicator, a negative cash flow, on one hand, indicates that the firm is financially troubled. No firm can keep on operating if cash flow is negative. On the other hand, positive cash flow, when cash is increasing, indicates that the firm is financially healthy (at least for the period) and can be able to pay its bills.
In order to avoid becoming insolvent, according to Brealey, Myers and Marcus (2001), most states in the US prohibit a company from paying dividends if doing so would make the company insolvent…state law prevents a company from paying a dividend if it cuts into the company's legal capital.
A manager can avoid becoming insolvent through periods of high sales by keeping properly keeping record of all its financial transactions. The manager will also be aided if he makes a projected cash flow so as to project the future expenses for the operation of the business.
You have been asked to analyze the financial position of three companies that operate in the food retail industry. The ratios for the last financial years are:
Company
A
B
C
Gross profit margin %
15
22
40
Net profit margin%
9
10
12
Return on capital employed %
15
13
16
Return on shareholders' fund
20
13
12
Stock days
18
25
45
Debtor days
9
32
65
Creditor days
9
42
55
Earnings per share
15p
20p
25p
Price earnings ratio
16
12
19
Dividend yield %
7
8
4
Comment on the companies' profitability
(Answer)
The profitability ratios determines the firm's income during a given time period. The profitability of a firm reflected in its gross profit margin ratio, net profit margin ratio, return on capital employed ratio, return on shareholders' fund, earning per share, price per earnings ratio and dividend yield.
The Gross Profit Margin reveals the proportion of money left over from revenues after accounting for the cost of goods sold. Also referred to as the "gross margin", it serves as the source for paying additional expenses and future savings. It is computed as:
where COGS is the Cost of Goods Sold.
As for the interpretation of the Gross Profit Margins of companies A (15%), B (22%), and C (40%), company C exhibits a high gross profit margin. Assume that the three companies are producing the same product, say, cell phone sold at a competitive price in dollars ($). Assume further that there are only three firms in the industry; merger or collusion is not allowed by law.
Company A, with gross profit margin of 15%, has a profit of $0.15 for every dollar that it earns on cell phone. Company B, gains a profit of $0.22 for every dollar that it earns from sale; and Company C, gains $0.40 profit in every dollar that it earns from sale of cell phone. The numbers also implies that Company C is the most efficient among the three companies because it has high gross profit margin.
The Net Profit Margin indicates how much profit a company makes for every dollar in revenue or sales. Ceteris paribus, the higher a company's profit margin compared to its competitors, the better (Investopedia 2010)
The net profit margin also reflects how well a firm is controlling its cost. In particular, a high net profit margin displays effectiveness in its sales into actual profit. Higher net margins provide the firm a significant competitive edge as it looks to improve and expand its operation (Stock Research Pro 2008); Low net margins indicate that the firm might have to take on more debt to pay its cost especially during economic downturns.
Companies that are able to expand their net margins over time will generally be rewarded with share price growth, as it leads directly to higher levels of profitability (Investopedia 2010).
From the given table, Company A has a net margin of 9%, company B of 10%, and Company C of 12%. Among these three companies, Company C has the competitive edge.
Return on Shareholders' Fund (ROSF) depicts the profit made from the total financial investment in the firm, which is in turn generated from and on behalf of the shareholders. It is computed as:
net profit bt x 100
shareholders' funds (bottom of balance sheet)
The benchmark ROSF percentage is between 20 to 25%.
A high ROSF percentage implies that the firm is profitable and has more profit available for the shareholders.
In application to the given table, Company A has ROSF of 20%, Company B has 13%, and Company C has 12%. The numbers suggests that Company A is the most profitable firm in the industry and it has generated more profit to its shareholders.
Hence in terms of ROSF percentage, Company A is the most profitable with ROSF percentage within the benchmark of 20 to 25%.
Earnings per Share is the portion of a firm's profit allocated to each outstanding share of common stock. It is also an measure of a firm's profitability. It is calculated as:
Earning per share is perceived as the single key variable in the determination of a share's price.
Using the data from the table, company A has EPS of 15p, company B has 20p, and company C has 25p. If I am going to buy a stock from one of these companies, I would surely buy a stock from Company C.
Comment on the companies' working capital management
(Answer) Return on Capital Employed (ROCE) ratio reveals how much profit can be earned from the investments that the shareholders have made in the company. It reflects the efficiency and profitability of a firm's capital investment and calculated as:
where EBIT is the Earnings Before Interest and Tax.
. In addition, the ROCE of a firm should always be higher than the rate of its borrowing because if otherwise, any increase in borrowing will surely reduce the earnings of the shareholders.
From the table above, Company A has an ROCE of 15%, Company B has 13%, and Company C has 16%. The numbers simply tell us that company A is earning 15% on the investment funds that its shareholders have invested in it; company B is earning 13%, and company C is earning 15% on the funds invested by its shareholders in the company.
Comment on the investment ratios. If you were going to buy one of these companies' shares which one would you choose? Explain your reasons.
(Answer)
Dividend Yield is a financial ratio that reflects how much a company pays out in dividend each year relative to its share price.
Dividend yield is the return on investment for a stock in the absence of any capital gains. Dividend yield is calculated as follows:
Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position…Investors who require a minimum stream of cash flow from their investment portfolio can secure this cash flow by investing in stocks paying relatively high, stable dividend yields (Investopedia 2010).
Looking at the values from the table above, the dividend yield in company A is 7%, while its 8% in company B and 4% in company C. If I am to choose to which company I will put my investment, I will have Company B.
Price Earning Ratio is simply a valuation ratio of a firm's current share price relative to its per-share earnings. It is calculated as:
A high PE of a firm implies that expecting higher growth in the future is being expected by the investors in relation to the companies with lower P/E. Comparing the P/E ratios of company A (16), company B (12) and company C (19), company C exhibits the highest price earning ratio. This implies that higher growth in the future is to be expected from company C relative to the other companies in the industry.
For a clearer interpretation of the price earning ratios, in reference to price earning ratio of company C, the company is currently trading at a price earning ratio of 19. This means that an investor is willing to pay $19 for a dollar of current earnings.
Also, price earning ratio is used by most people as indicator of the value of a stock. On the one hand, a low price earning ratio connotes that the company is undervalued and in that case, the company stock is perceived to be a good deal. On the other hand, a price earning ratio that is too high implies that the company is overvalued and obviously, not a good deal to buy.
Most of firms make a big portion of their sales on credit and the so-called Debtor Days is a gauge for the average time that payment takes. The quality of a firm's debtors is said to be decreasing if the debtor days is increases. Increases in debtor days also indicates the possibility of defaults (debtor not paying debt to firm), and also an indication of weakening cash flow. In general, lower debtor days are better for a firm.
For an investor, he should be aware of the changes in debtor days of the firm where he invested. Very large increases or persistent increases in debtor days may reveal changes in the operation of the business though it may not be bad at all, it can be a signal of potential problems.
Data of the three firms shows that company A's debtor days is 9, for company B it is 32, and company C it is 65. Company A has the lowest debtor days, which implies that it takes an average of 9 collection days for the firm's debtor to pay its debt to the firm. If Debtor Days would be my basis in choosing in which company to invest, I will invest to company A because as investor, I will have to ensure that there will be less chances of default from the debtors' part for my investment to payoff.
The Creditor Days is the average time that a firm takes to pay its creditors…Lengthening creditor days imply that the firm fails to pay its creditors (Money Terms 2010).
Company A has 9 creditor days while company B has 42 creditor days, and company C has 55 creditor days. The data reveals that company A is a good debtor to its creditors because it only takes an average of 9 days for the firm to pay its debt.
Generally, based from the ratios presented in the table, I will more likely invest in company A because of the good investment practices of the company as reflected in the values of its price-earning ratio, dividend yield, debtor days and creditor days. As an investor, I would of course choose a company which I perceived to be financially healthy as indicated by its financial ratios.
